I mentioned in last week’s blog entry that during my trips to New York, Washington and Hangzhou in the past two weeks one of the common themes was concern about rising debt levels and weaknesses in the banking sector. Another theme – one which I want to discuss in this entry – was the possible impact of China’s rebalancing on US and global interest rates. A lot of people were very concerned that if China does indeed rebalance, US interest rates will soar.
The argument runs like this. If China raises the consumption share of GDP faster than investment declines, this will result in a reduction in China’s current account surplus. Clearly if China’s current account surplus drops, the amount of capital it exports must drop in tandem – since a rising share of consumption means a declining share of savings and so a declining excess of savings over investment which must be exported.
But because it is recycling the world’s (and history’s) largest current account surplus, China is one of the world’s largest purchasers of US government bonds. If China’s current account surplus declines, and so China sharply cuts back on its purchases of US government bonds, this should automatically cause US interest rates to rise.
In at least half the meetings I attended this was the argument. Fortunately for me, just after I returned to Beijing Martin Feldstein made the same argument in a Project Syndicate blog entry. He starts out;
China’s new five-year plan will have important implications for the global economy. Its key feature is to shift official policy from maximizing GDP growth toward raising consumption and average workers’ standard of living. Although this change is driven by Chinese domestic considerations, it could have a significant impact on global capital flows and interest rates.
He then goes on to explain that success in raising the consumption share of GDP necessarily has current account implications:
China now plans to raise the relative growth rate of real wages and to encourage increased consumer spending. There will also be more emphasis on expanding service industries and less on manufacturing. State-owned enterprises will be forced to distribute more of their profits. The rising value of the renminbi will induce Chinese manufacturers to shift their emphasis from export markets to production for markets at home. And the government will spend more on low-income housing and to expand health-care services.
All of this will mean a reduction in national saving and an increase in spending by households and the Chinese government. China now has the world’s highest saving rate, probably close to 50% of its GDP, which is important both at home and globally, because it drives the country’s current-account surplus.
…The future reduction in China’s saving will therefore mean a reduction in China’s current-account surplus – and thus in its ability to lend to the US and other countries. If the new emphasis on increased consumption shrank China’s saving rate by 5% of its GDP, it would still have the world’s highest saving rate. But a five-percentage-point fall would completely eliminate China’s current-account surplus. That may not happen, but it certainly could happen by the end of the five-year plan.
So far I more or less agree with Feldstein. I say “more or less” because of course I am much more skeptical than he is that China will be able to raise the growth rate of consumption. That doesn’t mean that China won’t rebalance, of course. It just means that it will rebalance via much slower GDP growth rather than much faster consumption growth.
The balance of payments must balance
But either way, as China rebalances, by definition the savings rate will contract as a share of GDP. In that case will the current account shrink? Probably. It is possible, of course, that investment will grow more slowly than savings, in which case the current account surplus would rise, but I suspect that this won’t happen. China is too dependent on investment, and any sharp reduction in its growth rate will translate into a collapse in GDP growth.
So I expect that China will keep investment rates higher than they otherwise should be in order to reduce the immediate impact of the slowdown. This will be more costly for China over the long run, and will mean that the slowdown extends over a period much longer than anyone now expects, but it will be a less disruptive process and easier to manage socially.
The probability, then, is that a rising share of consumption will result in a declining current account surplus. Feldstein then makes the argument that I heard repeatedly in my meetings and have often read in the press:
If it does, the impact on the global capital market would be enormous. With no current-account surplus, China would no longer be a net purchaser of US government bonds and other foreign securities. Moreover, if the Chinese government and Chinese firms want to continue investing in overseas oil resources and in foreign businesses, China will have to sell dollar bonds or other sovereign debt from its portfolio. The net result would be higher interest rates on US and other bonds around the world.
It sounds pretty straightforward, right? The PBoC is a huge buyer of US government bonds. If it is forced to stop buying because of a reduction in China’s current account surplus, this should cause yields to rise. Fewer buyers and the same amount of sellers means that prices have to drop and yields rise.
Of course this doesn’t necessarily have to happen, as Feldstein notes:
Whether interest rates do rise will also depend on how US saving and investment evolves over the same period. America’s household saving rate has risen since 2007 by about 3% of GDP. Corporate saving is also up. But the surge in the government deficit has absorbed all of that extra saving and more.
He, however thinks a cut back in Chinese recycling is likely to cause to US, and global, yields to rise. The final sentence in his piece is: “If Americans’ demand for housing picks up and businesses want to increase their investment, a clash between China’s lower saving rate and a continued high fiscal deficit in the US could drive up global interest rates significantly.”
But, but, but…
I know the idea that reduced PBoC purchases will lead to higher US interest rates is part of a very widely-held consensus, and so I am reluctant to disagree too quickly, especially when someone as smart as Martin Feldstein makes the case, but I have to say that there is something about this argument that really bothers me. I don’t think a decline in the amount of capital recycled by China, whether through the PBoC or through other institutions, will likely lead to higher US interest rates at all.
The reason I say this is because if we accept this argument, then it seems to me that we are also saying that one way for the US to reduce interest rates is to allow its current account deficit to explode to significantly higher levels. Why? Remember that foreigners don’t fund fiscal deficits. They fund current account deficits, and they do so automatically. As long as the US runs a current account deficit, in other words, it will receive exactly the same amount of net capital inflows as the size of its current account deficit. So if the US current-account deficit doubles, for example, net foreign inflows will double too.
Will that cause US interest rates to decline? Yes, if US borrowing, especially US government borrowing, stays the same. But will it? Probably not. If the US current account surplus rises because of a surge in US investment, then I would argue that the increase in the amount of savings the US imports is matched by an equivalent increase in the need for savings, and so the impact on US rates is likely to be minimal. Of course if soaring US investment (and with it soaring jobs) cause Americans to feel richer and so increase their consumption, interest rates might even rise.
What if the rise in the US current account deficit is caused not by an increase in US investment but rather by a reduction in foreign (e.g. Chinese) consumption, as might have happened in the past decade? In that case the diverting of demand from the US to China should cause a rise in US unemployment and a reduction in US growth. Washington would try to counteract the diverted demand and rising unemployment with an increase in the fiscal deficit, just as it is doing now, or the Fed might try to counteract it by keeping rates low and encouraging a surge in consumer financing, as happened before 2007. Either way US debt levels would surge.
In that case what would happen to US interest rates? If the increase in the fiscal deficit or consumer borrowing was large enough, rates are as likely to rise as to fall. And remember that rising unemployment should reduce the household savings rate, which would counteract to some extent the increased amount of global savings the US is importing through its current account deficit.
I guess this is just a long way of saying that an increase in the US current account deficit can be contractionary for the economy, and if it results in declining interest rates, we should be clear about why. It is not because the US is lucky enough to have eager foreigners lending it money. It is because a rising current account surplus can slow the economy and weak growth is likely to be associated with low interest rates.
Less foreign financing
And the reverse is true. If China’s current account surplus declines, there are, very broadly, two ways this can affect the US. On the one hand the surplus can simply be transferred to another country. For example if China’s current account surplus declines because it decides to stockpile larger amounts of commodities at higher prices, it will simply shift the need to recycle its current account surplus to a commodity exporter – say Brazil.
In that case the total US current account deficit is unchanged, and by definition the net capital the US imports is also unchanged. Brazil will do what China was doing – buy US government bonds directly or indirectly.
On the other hand a rise in Chinese consumption could cause both the Chinese current account surplus and the US current account deficit to decline. In that case of course China would buy fewer US dollar assets and so fewer US government bonds. This is more or less Martin Feldstein’s scenario.
But in that case the reduction in the US current account deficit would be expansionary for the economy in a way similar to an increase in the fiscal deficit. Both are expansionary. So the impact on the current account would probably be offset by a reduction in fiscal spending.
So yes, the PBoC, and foreigners more generally, would be buying fewer US government bonds, but the US government would also be issuing fewer government bonds, in which case it is not at all obvious whether US interest rates will rise or not. In fact I don’t think it would make any difference, except to the extent that it impacts US growth. If a consequence of a reduction in China’s current account surplus is much faster US growth, then probably interest rates would indeed rise in the US, but this doesn’t seem like a bad thing at all to me. At any rate whether or not interest rates do indeed rise would depend on Washington’s fiscal and monetary reactions to the growth.
Regular readers of my newsletter might wonder if I am not just making a variation of my old Beijing-is-not-Washington’s-banker argument. In fact I am. The idea that PBoC purchases of US government bonds is part of a discrete lending decision by Beijing, and that Washington must worry that one day Beijing might pull the plug on this lending, is almost utter nonsense. Chinese purchases of US assets are an automatic consequence of the trade balance between the two countries.
If the US wants foreigners to “lend” it more money, all it has to do is engineer a larger trade deficit. If it wants to reduce foreign lending, it must have a smaller trade deficit. That’s pretty much all there is to it. So warnings about what bad things might happen to the US if China stops buying US government bonds are no different that warnings about what bad things might happen to the US if its trade deficit contracts.
In other words: it depends. Most of us would assume that a contracting trade deficit is expansionary for the US economy and therefore a good thing. In that case fewer purchases of US dollar assets by the PBoC and other foreigners must also be a good thing because one is simply the obverse of the other.
But it’s not necessarily a good thing. It depends how it happens. If the US trade deficit contracted because soaring US unemployment caused investment to collapse (i.e. faster than nominal savings decline), it would undoubtedly be very painful for the US. But if the US trade deficit contracted because Chinese consumers imported more US goods, I think everyone would be pretty pleased about it, and the interest rate consequences be damned.
This is an abbreviated version of the newsletter that went out last week. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at chinfinpettis@yahoo.com, stating your affiliation, please. Investors who are clients of Shenyin Wanguo Securities will already receive the newsletter. Investors who are not clients but who want to buy a subscription should write to me. also at that address.
I hope the Chinese do increase their consumption for their sakes. Since they are working and earning the money, they should get the benefits (i.e. more consumption) of that work.
Too much of our governments (and its apologists in the economics profession) efforts seem to be directed at pretending that the “gravy train” in the US need never reach an end.
Just as Chinese excess investment, driven by the Chinese government’s bad policies, must end, so must US (and European) excess consumption end (similarly driven by the US and Euro governments’ bad policies).
Exactly when either of these inevitable adjustments will occur is impossible to say. But the rapidly approaching defaults in Europe, and the also approaching fiscal crisis in the US, make it seem that it will be soon.
However, recent observation of many nations indicates that irrational policies can continue much longer than a rational observer would think likely.
One would think that it would be easier for China to weather the coming adjustments better than the US or Europe but being a longtime reader of this blog, I have learned enough about what I don’t know about economics to be unsure of that.
Any thoughts on this Professor?
PS. Thanks again for your continued postings. I look forward to reading them.
Michael,
I have a question about how China’s rebalancing will effect the U.S. In your recent FT piece, you suggested the U.S. should push for the use of multi-currency special drawing rights as reserves, as a way to make it harder for others to co-opt our consumption.
But say we did that. The Yuan rises some, Chinese consumption rises as a share of GDP. And the dollar falls some and consumption increases as a share of GDP.
For Americans, there would be the be the employment benefit, but it would exacerbate commodity inflation. Already, demand destruction is occurring– gasoline consumption is down 3.5% YoY–and we haven’t even passed $4/gal. yet nationally.
Is this just part of a process that we should accept since the net benefit (jobs) is so much more important? I guess it would be good for domestic energy producers, too. (I’m a natural gas bug, we’re likely gold bugs in our enthusiasm, but at least we can point to cost/btu spread between oil and gas.
Thanks for this analysis. The “but interest rates will rise” argument has always bugged me, too, though I’m not equipped with the knowledge of financial markets to articulate exactly why. It just seems like an argument in favor of perpetuating the same problematic global dynamic that helped get us into this mess to begin with. In other words, if a consequence of making the right changes is potentially higher interest rates, then maybe interest rates SHOULD rise…Thanks for helping to fill in the blanks.
In terms of current account deficits, I have a question about tariffs. If the US’ applied tariff rates are below the bound tariff rates that we cannot exceed per our trade agreements, would it be a bad idea to raise tariffs on manufactured goods to the highest level possible (or, perhaps, not quite that high) within the scope of our agreements? I know that “tariff” has become something of a bad word in the last decade, and that every time duties are applied to an import, people start screaming “Smoot-Hawley” and “protectionism” and “trade war” and “Great Depression,” etc….But it seems to me like this would be a very simple and efficient way of doing a number of healthy things: 1) increasing gov’t revenue without raising income taxes; 2) encouraging more domestic production and, perhaps, exports from the US; 3) discouraging imports; and 4) encouraging exporting countries to consume more of their own production. No one would be talking about triple-digit, Smoot-Hawley-type tariffs, just tariffs that are, say 10-15% as opposed to 0-5%, which, as I see it, would be far from high enough to lead to the downfall of global commerce…
Mr Pettis,
You are ignoring the effects of demographics which may be the single largest factor affecting interest rates worldwide going forward. The first of the Baby Boomers turned 65 on 1-Jan-2011, as the baby boomers march into retirement, they will try to draw down whatever savings they have. I say try to draw down because much of the real savings have actually been squandered on a series of bubbles and government spending. Witness Japan where the savings rate has dropped from 20+ % to less than 2 %. EU demographics are even worse than US and much of their savings have already been squandered away in supporting the peripheral economies. China can have high savings rate for 5-6 years more before the demographic time bomb of the 1 child policy goes off. My argument is that once China’s dependency ratio bottoms and starts increasing (It may have already bottomed), it may be in no position to export savings. The bonds issued by the governments of US, EU and Japan largely represent past consumption and are unrepayable except through money printing. Real interest rates will have to rise because of a shortage of capital. Nominal rates may remain low because of central bank printing.
Prof Pettis,
Excellent piece. Best in months. The problem with US consumption IMO is that most of it is heavily driven by the asset class. That is people who’s confidence rises and falls with the price of the size of the assets. If you look at the majority of America their spending hasn’t changed much since the “bottom” of the recession. Look at Walmart and grocery store sales. These consumers would benefit from a shift of jobs from China but this would take time as factories would need to be planned and built. In the meant time demand in the US and China could occur simultaneously right?
China’s 12th Five Year Plan. A Necessary Revisiting. Part II. The Reality I recommend this blog (also part I) by Steve Dickinson over at China Law Blog for those optimists out there waiting for the Great Rebalancing.
Instead of analysing the US and China as TWO countries, it could sometimes be better to look at them as ONE country with two central banks and two government budgets. All thoughts of flows here and there could be left out, and focus comes to the pricing of assets and goods/services.
-The country “USA/China” has a quite balanced foreign trade.
-The country “USA/China” is stimulating demand through its US-budget.
- The country “USA/China” has two central banks, however only one of them (the Fed) operates. The Chinese central bank merely exchanges USD for CNY at a fixed rate. Thus the country “USA/China” practically only has ONE currency. Interest rates however are awkwardly and ineccetively regulated throughout “USA/China” area creating market imperfections to utilise.
Broadly speaking USA/China is developing well, annual growth at some 5%. Some people worry about money-printing, but Fed just prints what the PBoC locks in – thus no printed money is released for circulation.
The major imbalance in “USA/China” has been wage inconergence. Rapidly increasing wages in the China area are step by step removing this factor, and the USA/China internal market is integrating well.
“China sharply cuts back on its purchases of US government bonds, this should automatically cause US interest rates to rise.”
If the liquidity of certain financial assets (i.e. treasury securities) is deep enough, they’ll mostly be influenced by asset pricing rather than supply demand. Remember long rate is an expectation of the path of future short rates which heavily depends on future inflation. If all else equal, including but not limited to Fed doing its job maintaining CPI @ 2%, US government credit untouched, etc. then US bonds sold by China will be picked up by rational investors at the appropriate price.
Who will buy the bonds? Fed certainly can do under the name of QE. Maybe that’s cheating. But banks also have excess reserves earning 0.25%, private investors can jump in bargain hunting too. I believe China’s action on its treasury holding of 9.6 trillion of outstanding public debt.
Prof Pettis
Nice to see you back in action after what has been “interesting times”.
Largely agree except for the following:
For example if China’s current account surplus declines because it decides to stockpile larger amounts of commodities at higher prices, it will simply shift the need to recycle its current account surplus to a commodity exporter – say Brazil.
In that case the total US current account deficit is unchanged, and by definition the net capital the US imports is also unchanged. Brazil will do what China was doing – buy US government bonds directly or indirectly
Yes, that might be the case, but just to play devil’s advocate, brazil or any other country for that matter may invest in other sovereign bonds. Again zero sum in the long run does not necessarily mean zero sum in the short to medium.
All of this overestimates the impact that a reduction or even elimination of China’s current account deficit would have on demand for US government bonds.
If China stops buying, someone else will step up.
The primary determinant for demand for US bonds are (1) expectations for US inflation. The higher the inflation expectation, the lower the demand for a given yield. (2) alternative investment opportunities. The more attractive equities, commodities, or corporate bonds look, the lower the demand for a given yield. (3) credit risk. Despite S&P’s report, this is negligible in the short-to-medium term since the US controls its own currency, like Japan and unlike Greece.
These are the fundamentals that drive the US government debt market. These fundamentals will never change, and China cannot change them. China is just another buyer. As recently as 2004, Japan was a bigger buyer than China, and it could become so again.
Michael,
In your posts you’ve laid out a scenario in which China does not experience a crash, but does endure prolonged deleveraging and stagnation. Second, you’ve suggested that inflation would prove fleeting. Third, when discussing the Euro, you suggested that at some not-too-distant point, the currency could very well founder.
Can you envision a scenario in which we see a European-centered financial crisis, a cratering Euro, reduced European demand for Chinese exports, and then a spiralling down asset prices in China? I see a very levered and connected world still, where a default in one country could trigger a cascade of bad debt issues in other countries.
“there is something about this argument that really bothers me”
like accounting identities that force a current account deficit to be offset by a capital account surplus, as you say
current account deficits are “self-funding” in that sense
the Fed sets the anchor interest rate, and among other things takes in account reasons for any change in the trade deficit, and whether or not those reasons are expansionary or contractionary, as you say
the market then translates the Fed rate, and expectations for it, to yield curves
that’s all there is to it
Isn’t this actually a 10,000ft view of the situation that disregards the difference between private and public investment and savings?
It will be interesting to see your opinion where the income will come from for that consumer spending. Will it be from a sharp decrease of public investment and lending to private citizens rather than SOE, will it be because of rebalancing between RE and other discretionary items (the net effect is zero here on the share of GDP initially), will it be due to rising icomes at a rate higher than the public fixed investment growth, will it be through revaluation?
Either way, I think you are talking about a seismic shock to the RE market and all construction related activity and jobs that are an outsized part of the Chinese economy.
And the argument that decreasing demand for UST will raise rates is valid as long as the Fed does not soak up the unwanted paper as this is the case currently and they have a standing pledge to continue supporting the economy, through low rates. If rates begin to rise, expect more episodes of the QE sequel. But printing money immediately lowers their purchasing power and the Chinese peg lowers the consumption power of the Chinese citizen who is at the margin with much lower disposable income.
Revaluation seems to be the most feasible approach to raise the share of consumption relative to GDP, but that will be mostly at the expense of the decreasing denominator.
In short: you cannot piggy back on someone’s currency and not experience the effects of currency devaluation, it is like wanting to have your cake and eat it too.
Prof Pettis,
Do you still regularly appear on CCTV’s program, Dialogue? thanks.
Dr. Pettis,
As always a very insightful piece.
I often think, though, that the fixation one sees on a bi-lateral analysis of US and China economic inter-relation over simplifies a more complex set of issues. If China pushes comsumption, reducing its current account surplus, it is not the case that there is a direct reduction in the US current account deficit, leading to a decline in investment into the US. That would only be true if these 2 economies operated in isolation from the rest of the world. I would think that if the global economy and the US economy grow, then there will be adequate investment via either a continued current account deficit in the US (perhaps with countries other than China) or higher savings inside the US. Interest may or may not rise in that case and the outcome may have as much to do with inflationary expectations as with specific changes in China.
I know that this is offf topic but can anyone tell me if China’s farmers are prohibited from exporting? I read a story about the farmer who committed suicide after cabbage prices droped from .25 cents (USD) per Kg to .02 per Kg. Someone should build a processing plant to freeze and ship them. Unless there is some dilberate attmept to use farmers as a tool to tame inflation.
http://news.xinhuanet.com/english2010/indepth/2011-04/26/c_13846082.htm